Charitable remainder trust; real estate investment
trust (REIT). This ruling illustrates the application of section
860E of the Code where a charitable remainder trust is a shareholder of a
real estate investment trust (REIT) or a partner of a partnership, and the
REIT or the partnership has excess inclusion income.

ISSUES

If a charitable remainder annuity trust or a charitable remainder unitrust,
as defined in section 664(d) of the Internal Revenue Code (collectively, charitable
remainder trusts), is a partner in a partnership or a shareholder in a real
estate investment trust (REIT), and if the partnership or the REIT has excess
inclusion income from holding a residual interest in a real estate mortgage
investment conduit (REMIC)—

(1) Does the charitable remainder trust have unrelated business taxable
income (UBTI) as defined in section 512, causing the charitable remainder
trust to lose its exemption from tax under section 664(c) for the taxable
year?

(2) Is the charitable remainder trust a disqualified organization as
defined in section 860E(e)(5)?

(3) Is the partnership (or REIT) subject to the pass-thru entity tax
under section 860E(e)(6)?

FACTS

In the following situations, Trust TR1 and Trust TR2 meet
all the requirements for exemption from tax under section 664(c) for the taxable
year, except for the possible treatment of excess inclusion income as UBTI
under section 860E(b).

Situation 1

Trust TR1, a charitable remainder trust, holds
a ten percent partnership interest in Partnership PRS.
Because PRS holds a residual interest in a REMIC, section
860C(a) requires PRS to take into account its daily portion
of the REMIC’s net income or net loss. For 2004, a portion of the REMIC
net income taken into account by PRS was an excess inclusion,
as defined in section 860E(c).

Situation 2

Trust TR2, a charitable remainder trust, holds
a ten percent equity interest in Corporation R, which
has elected, and is qualified, to be treated as a REIT under subchapter M
of the Code. Because R holds a residual interest in
a REMIC, section 860C(a) requires R to take into account
its daily portion of the REMIC’s net income or net loss. For 2004,
a portion of the REMIC net income taken into account by R was
an excess inclusion, as defined in section 860E(c). R’s
real estate investment trust taxable income (within the meaning of section
857(b)(2), excluding any net capital gain) was zero.

LAW

In general, section 702 requires each partner to take into account separately
its distributive share of partnership items. Section 702(a)(7) requires a
partner to take into account separately its distributive share of a partnership’s
“other items of income, gain, loss, deduction, or credit, to the extent
provided in regulations prescribed by the Secretary.” Section 1.702-1(a)(8)(ii)
provides:

Each partner must also take into account separately the partner’s
distributive share of any partnership item which, if separately taken into
account by any partner, would result in an income tax liability for that partner,
or for any other person, different from that which would result if that partner
did not take the item into account separately.

Section 702(b) provides:

The character of any item of income, gain, loss, deduction, or credit
included in a partner’s distributive share under paragraphs (1) through
(7) of [section 702(a)] shall be determined as if such item were realized
directly from the source from which realized by the partnership, or incurred
in the same manner as incurred by the partnership.

shall be allocated among the shareholders of such trust in proportion
to the dividends received by such shareholders from such trust, and

(2) any such amount allocated to a shareholder under paragraph (1) shall
be treated as an excess inclusion with respect to a residual interest held
by such shareholder.

Rules similar to the rules of the preceding sentence shall apply also
in the case of regulated investment companies, common trust funds, and organizations
to which part I of subchapter T [(sections 1381-1383)] applies.

Section 664(c) provides that a charitable remainder trust “shall,
for any taxable year, not be subject to any tax imposed by [subtitle A], unless
such trust, for such year, has [UBTI] (within the meaning of section 512,
determined as if part III of subchapter F [(unrelated business income tax
(UBIT) provisions under sections 511-515)] applied to such trust).”

Section 1.664-1(c) provides:

If a charitable remainder trust has any [UBTI] (within the meaning of
section 512 and the regulations thereunder, determined as if part III, subchapter
F, chapter 1, subtitle A of the Code applied to such trust) for any taxable
year, the trust is subject to all of the taxes imposed by subtitle A of the
Code for such taxable year. . . . The taxes imposed by subtitle A of the
Code upon a nonexempt charitable remainder trust shall be computed under the
rules prescribed by subparts A and C, part 1, subchapter J, chapter 1, subtitle
A of the Code [(sections 641-646 and 661-664)] for trusts which may accumulate
income or which distribute corpus.

Section 860E(b) provides, “If the holder of any residual interest
in a REMIC is an organization subject to the tax imposed by section 511, the
excess inclusion of such holder for any taxable year shall be treated as [UBTI]
of such holder for purposes of section 511.”

Section 860E(e)(6)(A) imposes a tax on certain REITs, partnerships and
other pass-thru entities (as defined under section 860E(e)(6)(B)). Section
860E(e)(6)(A) provides, “If, at any time during any taxable year of
a pass-thru entity, a disqualified organization is the record holder of an
interest in such entity, there is hereby imposed on such entity for such taxable
year a tax equal to the product of—(i) the amount of excess inclusions
for such taxable year allocable to the interest held by such disqualified
organization, multiplied by (ii) the highest rate of tax specified in section
11(b)(1).” For purposes of section 860E(e)(6), section 860E(e)(6)(B)
defines the term “pass-thru entity” to include any REIT and any
partnership. Section 860E(e)(5)(B) defines the term “disqualified organization”
to include “any organization (other than a cooperative described in
section 521) which is exempt from tax imposed by [chapter 1] unless such organization
is subject to the tax imposed by section 511.”

Section 1.860E-2(b) of the Income Tax Regulations contains rules relating
to the application of the pass-thru entity tax under section 860E(e)(6)(A).
Among other things, § 1.860E-2(b)(4) provides, “Dividends
paid by a RIC or by a REIT are not preferential dividends within the meaning
of section 562(c) solely because the tax expense incurred by the RIC or REIT
under section 860E(e)(6) is allocated solely to the shares held by disqualified
organizations.”

ANALYSIS

1. Effect of allocation of excess inclusion income to a
charitable remainder trust on its eligibility for exemption from tax under
section 664(c) for the taxable year.

As a partner of PRS, TR1 has
a distributive share of the excess inclusion income of PRS,
as determined under section 702(a) and (b). If section 860E(b) characterizes
the excess inclusion income allocated to TR1 as UBTI, TR1 will
lose its exemption under section 664(c) for 2004. Section 860E(b) treats
excess inclusion income as UBTI to the holder of a REMIC residual interest
but only if the holder “is an organization subject to the tax imposed
by section 511” (that is, subject to the UBIT). In the case of a charitable
remainder trust, section 664(c) employs the definitional rules of section
512 and the other UBIT provisions to determine whether any of the trust’s
income is UBTI, but it does not subject the trust to section 511. (See the
discussion below under Issue 2.)

Whether section 860E(b) characterizes the excess inclusion income of
charitable remainder trusts as UBTI should be determined in light of the intent
underlying section 860E and other REMIC provisions. A number of the REMIC
provisions are comprehensive and complementary by design. If a tax-exempt
entity holds the REMIC residual interest, the REMIC provisions ensure the
taxation of excess inclusion income in all events, whether or not the tax-exempt
holder of the REMIC residual interest is a disqualified organization. A disqualified
organization (as defined in section 860E(e)(5)(B)) is a tax-exempt entity
that is not subject to UBIT. Thus, a disqualified organization cannot be
subject to a tax on any excess inclusion income allocable to it. But other
tax exempt entities are generally subject to UBIT and could be subject to
a tax on excess inclusion income, subject to other requirements.

With respect to disqualified organizations, a REMIC is required to have
in place “reasonable arrangements designed to ensure that . . . residual
interests in [the REMIC] are not [transferred to] disqualified organizations
. . . .” Section 860D(a)(6). If an entity nonetheless transfers a
REMIC residual interest to a disqualified organization, section 860E(e)(1)
imposes a tax on the transferor. Further, if a pass-thru entity has a record
equity owner that is a disqualified organization, the pass-thru entity must
pay a tax on the amount of excess inclusion income that is allocable to the
disqualified organization. Section 860E(e)(6)(A). With respect to other
tax-exempt entities (which are not disqualified organizations), section 860E(b)
generally provides that, if a tax-exempt entity that is subject to the UBIT
holds a REMIC residual interest, the excess inclusion income of that holder
is UBTI.

Sections 860E(e)(6)(A) and 860E(b) are complementary provisions that
should be interpreted consistently. If a pass-thru entity (whose equity owners
may be disqualified organizations or other tax-exempt entities) holds REMIC
residual interests, the two sections ensure that the excess inclusion income
is taxable either to the pass-thru entity (under section 860E(e)(6)(A)) or
to its tax-exempt equity owner that is subject to UBIT (under section 860E(b)).
Characterizing as UBTI only the excess inclusion income that is allocable
to tax exempt entities that are actually subject to the UBIT causes the two
sections to operate consistently.

As discussed below, a charitable remainder trust can never be subject
to the UBIT. Accordingly, TR1’s distributive share
of PRS’s excess inclusion income is not UBTI under
section 860E(b).

2. Status of a charitable remainder trust as a disqualified
organization.

TR1 and TR2 are charitable
remainder trusts. Under section 664(c), a charitable remainder trust is exempt
from tax under subtitle A of the Code, including chapter 1, unless it has
UBTI for the taxable year (determined as if UBIT applied to the charitable
remainder trust). But if a charitable remainder trust has UBTI, it loses
its section 664(c) tax exemption for the taxable year, and the resulting tax
liability is determined under the trust tax provisions of the Code. See § 1.664-1(c).
Thus, if a charitable remainder trust has UBTI, that trust becomes an organization
subject to the tax imposed by sections 1 and 641 but not to
the UBIT. Because a charitable remainder trust can never be subject to the
UBIT, it is a disqualified organization, as defined in section 860E(e)(5).
As charitable remainder trusts, TR1 and TR2 are
disqualified organizations.

3. Application of the pass-thru entity tax under section
860E(e)(6)(A).

PRS and R are pass-thru entities,
as defined in section 860E(e)(6)(B). For purposes of section 860E(e)(6)(A), PRS is
treated as having allocated excess inclusion income to TR1,
a disqualified organization, equal to its distributive share of the excess
inclusion income of PRS determined under section 702.
Because R’s real estate investment trust income
is zero, all of R’s excess inclusion income is
allocable to its shareholders. R’s excess inclusion
income is allocable to TR2, also a disqualified organization,
in proportion to the dividends paid to TR2 (determined
without regard to any special allocation to TR2 of the
expense for the tax under section 860E(e)(6)). See § 1.860E-2(b)(4)
(providing an exception to the preference dividend rule in section 562(c)).

PRS and R have record equity
owners that are disqualified organizations, to which excess inclusion income
is allocable. Thus, PRS and R are
subject to a tax under section 860E(e)(6)(A) on the amount of the excess inclusion
income allocable to TR1 and TR2,
respectively, at the highest rate specified in section 11(b)(1).

HOLDINGS

(1) Excess inclusion income allocated to a charitable remainder trust
is not UBTI to the charitable remainder trust and thus does not affect the
charitable remainder trust’s exemption from tax under section 664(c)
for the taxable year.

(2) A charitable remainder trust is a disqualified organization for
purposes of section 860E.

(3) A pass-thru entity that has excess inclusion income allocable to
a charitable remainder trust is subject to the pass-thru entity tax under
section 860E(e)(6)(A).

DRAFTING INFORMATION

The principal author of this revenue ruling is Anna Kim of the Office
of the Associate Chief Counsel (Financial Institutions and Products). For
further information regarding this revenue ruling, contact Anna Kim at 202-622-3735.